NBER WORKING PAPER SERIES

NON—MONETARY EFFECTS OF THE FINANCIALCRISIS IN THE PROPAGATION OF THE GREAT DEPRESSION

Ben S. Bernanke

Working Paper No. 10514

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge MP 02138

January 1983

Stanford Graduate School of Business and Hoover Institution. Ireceived useful comments from too many people to list here by name,but I am grateful to each of them. The National Science Foundationprovided partial research support. The research reported here ispart of the NBER's research program in Economic Fluctuations. Anyopinions expressed are those of the author and not those of theNational Bureau of Economic Research.

NBER Working Paper #1054January 1983

Non-Monetary Effects of the Financial Crisisin the Propagation of the Great Depression

ABSTRACT

This paper examines the effects of the financial crisis of the 1930s onthe path of aggregate output during that period. Our approach iscomplementary to that of Friedman and Schwartz, who emphasized the monetaryimpact of the bank failures; we focus on non-monetary (primarily credit-related) aspects of the financial sector--output link and consider theproblems of debtors as well as those of the banking system. We arguethat the financial disruptions of 1930-33 reduced the efficiency of thecredit allocation process; and that the resulting higher cost and reducedavailability of credit acted to depress aggregate demand. Evidence suggeststhat effects of this type can help explain the unusual length and depth ofthe Great Depression.

Ben S. BernankeStanford Graduate School of BusinessStanford, California 94305

(415) 497—3285(415) 497—2763

I. Introduction

During 1930—33 the U.S. financial system experienced conditions

that were among the most difficult and chaotic in its history. Waves

of bank failures culminated in the shutdown of the banking system (and

of a number of other intermediaries and markets) in March 1933. On

the other side of the ledger, exceptionally high rates of default and

bankruptcy affected every class of borrower except the Federal

government.

An interesting aspect of the general financial crises—-most

clearly, of the bank failures——was their coincidence in timing with

adverse developments in the maeroeconomy.1 Notably, an apparent

attempt at recovery from the 1929—30 recession2 was stalled at the

time of the first banking crisis (November—December 1930); the

incipient recovery degenerated into a new slump during the mid-1931

panics; and the economy and the financial system both reached theirrespective low points at the time of the bank "holiday" of March 1933.Only with the New Deal's rehabilitation of the financial system in

1933—35 did the economy begin its slow emergence from Depression.

A possible explanation of these synchronous movements is that the

financial system simply responded, without feedback, to the declinesin aggregate output. This is contradicted by the facts that problemsof the financial system tended to lead output declines, and thatsources of financial panics unconnected with •the fall in U.S. outputhave been documented by many writers. (See Section V below. )

Among explanations that emphasize the opposite direction of

causality, the most prominent is the one due to Friedman and Schwartz

(1963). Concentrating on the difficulties of the banks, they pointed

—2—

out two ways in which these worsened the general economic contraction:

first, by reducing the wealth of bank shareholders; second, and much

more important, by leading to a rapid fall in the supply of money.

There is much support for the monetary view. However, it is not a

complete explanation of the link between the financial sector and

aggregate output in the 1930s. One problem is that there is no theory

of monetary effects on the real economy that can explain protracted

non-neutrality. Another is that the reductions of the money supply in

this period seems quantitatively insufficient to explain the

subsequent falls in output. (Again, see Section V.)

The present paper builds on the Friedman-Schwartz work byconsidering a third way in which the financial crises (in which weinclude debtor bankruptcies as well as the failures of banks and other

lenders) may have affected output. The basic premise is that, because

markets for financial claims are incomplete, intermediation between

some classes of borrowers and lenders requires nontrivial

market—making and information—gathering services. The disruptions of

1930—33 (we shall try to show) reduced the effectiveness of the

financial sector as a whole in performing these services. As the real

costs of intermediation increased, some borrowers (especially

households, farmers, and small firms) found credit to be expensive and

difficult to obtain. The effects of' this credit squeeze on aggregate

demand helped convert the severe but not unprecedented downturn of

1929—30 into a protracted depression.

It should be stated at the outset that our theory does not offer

a complete explanation of the Great Depression (for example, nothing

Is said about 1929—30). Nor is it neàessarily inconsistent with some

—3—

existing explanations.3 If'owever, it does have the virtues that,

first, it seems capable (in a way in which existing theories are not)

of explaining the unusual length and depth of the Depression; and,

second, it can do this without assuming markedly irrational behavior

by private economic agents. Since the reconciliation of the obvious

inefficiency of the Depression with the postulate of rational private

behavior remains a leading unsolved puzzle of macroeconomics, these

two virtues alone provide motivation for serious consideration of this

theory.

There do not seem to be any exact antecedents of the present

paper in the formal economics literature. The work of Chandler

(1970,1971) provides the best historical discussions of the general

financial crisis extant; however, he does not develop very far the

link to macroeconomic performance. Beginning with Fisher (1933) and

Hart (1938), there is a literature on the macroeconomic role of inside

debt; an interesting recent example is the paper by Mishkin (1978),

which stresses household balance sheets and liquidity. Friedman

(1981) has written on the relationship of credit and aggregate

activity. Minsky (1977) and Kindleberger (1978) have in several

places argued for the inherent instability of the financial system,

but in doing so have had to depart from the assumption of rational

economic behavior.5 None of the above authors has emphasized the

effects of financial crisis on the real costs of credit

intermediation, the focus of the present work.

The paper is organized as follows: Section II presents some

background on the 1930—33 financial crisis, its sources, and its

correspondence with aggregate output movements.

Section III begins the principal argument of the paper. We

explain how the runs on banks and the extensive defaults could have

reduced the efficiency of the financial, sector in performing itsintermediary functions. Some evidence of these effects is introduced.

Possible channels by which reduced financial efficiency mighthave affected output are discussed in Section IV. Reduced—form

estimation results, reported in Section V, suggest that augmenting a

purely monetary approach by our theory significantly improves the

explanation of the financial sector—output connection in the short

run. Section VI looks at the persistence of these effects.

Some international aspects of the financial sector—aggregateoutput link are briefly discussed in Section VII. Section VIIIconcludes.

I• I.!12. LL22.L 2!The problems faced by the U.S. financial system between October

1930 and March 1933 have been described in detail by earlier authors,6

but it will be useful to recapitulate some principal facts here.

Given this background, we will turn attention to the more central

issues of the paper.

The two major components of the financial collapse were the loss

in confidence in financial institutions, primarily commercial banks,

and the widespread insolvency of debtors. We give short discussionsof each of these components and of their joint relation to aggregatefluctuations.

1. The failure of financial institutions. Most financialinstitutions (even semi—public ones, like the Joint Stock Land Banks)

—5—

came under pressure in the 1930s. Some, such as the insurance

companies and the mutual savings banks, managed to maintain something

close to normal operations. Others, like the building—and—loans

(which, despite their ability to restrict withdrawals by depositors,

failed in significant numbers) were greatly hampered in their attempts

to carry on their business.7 Of most importance, however, were the

problems of the commercial banks. The significance of the banking

difficulties derived both from their magnitude and from the central

role commercial banks played in the financial system.8

The great severity of the banking crises in the Depression is

well known to students of the period. The percentages of operating

banks which failed in each year from 1930 to 1933 inclusive were 5.6,

10.5, 7.8, and 12.9; because of failures and mergers, the number of

banks operating at the end of 1933 was only just above half the number

that existed in 1929. Banks that survived experienced heavy losses.

The sources of the banking collapse are best understood in the

historical context. The first point to be made is that bank failures

were hardly a novelty at the time of the Depression. The U.S. system,

made up as it was primarily of small, independent banks, had always

been particularly vulnerable. (Countries with only a few large banks,

such as Britain, France, and Canada, never had banking difficulties on

the American scale.) The dominance of small banks in the U.S. was due

in large part to a regulatory environment which reflected popular

fears of large banks and "trusts"; for example, there were numerous

laws restricting branch banking at both the state and national level.

Competition between the state and national banking systems for member

banks also tended to keep the legal barriers to entry in banking very

—6—

low.10 In this sort of environment, a significant nuiber of failures

was to be expected and probably was even desirable. Failures due to

"natural causes" (such as the agricultural depression of the 1920s

upon which many small, rural banks foundered) were common.11

Besides the simple lack of economic viability of some marginal

banks, however, the U.S. system historically suffered also from a more

malign source of bank failures; namely, financial panics. The fact

that liabilities of banks were principally in the form of fixed—price,

callable debt (i.e., demand deposits), while many assets were highly

illiquid, created the possibility of the perverse expectationalequilibrium known as a "run" on the banks. In a run, fear that a bankmay fail induces depositors to withdraw their money, which in turnforces liquidation of the bank's assets. The need to liquidatehastily, or to dump assets on the market when other banks are alsoliquidating, may generate losses that actually do cause the bank tofail. Thus the expectation of failure, by the mechanism of the run,tends to become self—confirming.12

An interesting question is why banks at this time relied on

fixed—price demand deposits, when alternative instruments might have

reduced or prevented the problem of runs.13 The answer is provided by

Friedman and Schwartz: They pointed out that, before the

establishment of the Federal Reserve in 1913, panics were usually

contained by the practice of suspending convertibility of bank

deposits into currency. This practice, typically initiated by loose

organizations of urban banks called clearinghouses, moderated the

dangers of' runs by making hasty liquidation unnecessary. In

conjunction with the suspension of convertibility practice, the use of

—7—

demand deposits created relatively little instability.1

However, with the advent of the Federal Reserve (according to

Friedman and Schwartz), this roughly stable institutional arrangement

was upset. Although the Federal Reserve introduced no specific

injunctions against the suspension of convertibility, the

clearinghouses apparently felt that the existence of the new

institution relieved them of the responsibility of fighting runs.

Unfortunately, the Federal Reserve turned out to be unable or

unwilling to assume this responsibility.

No serious runs occurred between World War I and 1930; but the

many pieces of bad financial news that came in from around the world

in 1930—32 were like sparks around tinder. Runs were clearly an

important part of the banking problems of this period. Some evidence

emerges from contemporary accounts, including descriptions of specific

events precipitating runs. Also notable Is the fact that bank

failures tended to occur in short spasms, rather than in a steady

stream (see Table 1, column 2 for monthly data on the deposits of

failing banks). The problem was not arrested until government

intervention became important in late 1932 and early 1933.

We see, then, that the banking crises of the early 1930s differed

from earlier recorded experience both in magnitude and in the degree

of danger posed by the phenomenon of runs. The result of this was

that the behavior of almost the entire system was adversely affected,

not just that of marginal banks. The bankers fear of runs, we shall

argue below, had important macroeconomic effects.

2. Defaults and bankru2tcies. The second major aspect of the

financial crisis (one that is currently much neglected by historians)

—8—

was the pervasiveness of debtor insolvency. Given that debt contracts

were written in nominal terms,15 the protracted fall in prices and

money incomes greatly increased debt burdens. According to Clark

(1933), the ratio of debt service to national income went from 9% in

1929 to 19.8% in 1932—33. The resulting high rates of default caused

problems for both borrowers and lenders.

The "debt crisis" touched all sectors. For example, about half

of all residential properties were mortgaged at the beginning of the

Depression; as of January 1, 19314

"The proportion of mortgaged owner—occupied houseswith some interest or principal in default was innone of the twenty—two cities [surveyed) less than21 percent (the figure for Richmond, Virginia); inhalf it was above 38 percent; in two (Indianapolisand Birmingham, Alabama) between 50 percent and 60percent; and in one (Cleveland), 62 percent. Forrented properties, percentages in default ranslightly higher." (note 16)

Because of the long spell of low food prices, farmers were in

more difficulty than homeowners. At the beginning of 1933, owners of

145% of all U.S. farms, holding 52% of the value of farm mortgage debt,

were delinquent in payments.17 State and local governments——many of

whom tried to provide relief for the unemployed——also had problems

paying their debts: As of March 19314, the governments of 37 of the

310 cities with populations over 30,000 and of three states had

defaulted on obligations.18

In the business sector, the incidence of financial distress was

very uneven. Aggregate corporate profits before tax were negative in

1931 and 1932, and after—tax retained earnings were negative in each

year from 1930 to 1933.19 But the subset of corporations holding more

than fifty million dollars in assets maintained positive profits

—9—

throughout this period, leaving the brunt to be borie by smaller

companies. Fabricant (1935) reported that, in 1932 alone, the losses

of corporations with assets of 850,000 or less equalled 33% of total

capitalization; for corporations with assets in the 850,000—$100,000

range, the comparable figure was 14%. This led to high rates of

failure among small firms.

Although the deflation of' the 1930s was unusually protracted,

there had been a similar episode as recently as 1921—22 which had not

led to mass insolvency. The seriousness of the problem in the Great

Depression was due not only to the extent of' the deflation but also tothe large and broad—based expansion of inside debt in the 19203.Persons surveyed the credit expansion of the pre—Depression decade in

a 1930 article: He reported that outstanding corporate bonds andnotes increased from $26.1 billion in 1920 to $47.1 billion in 1928,and that non—Federal public securities grew from $11.8 billion to

833.6 billion over the same period. (This may be compared with a 1929

national income of' $86.8 billion.) Perhaps more significantly, during

the twenties small borrowers, such as households and unincorporated

businesses, greatly increased their debts. For example, the value of

urban real estate mortgages outstanding increased from $11 billion in

1920 to $27 billion in 1929, while the growth of consumer installment

debt reflected the introduction of major consumer durables to the mass

market.

Like the banking crises, then, the debt crisis of the 1930s was

not qualitatively a new phenomenon; but it represented a break with

the past in terms of its severity and pervasiveness.

3. Correlation of the financial crisis with macroeconomic

-10—

activ1. The close connection of the stages of the financial crisis(especially the bank failures) with changes in real output has been

noted by Friedman and Schwartz and by others. An informal review of

this connection is facilitated by the monthly data in Table 1. Column

1 is an index of real industrial production. Columns 2 and 3 are the

(nominal) liabilities of failing banks and non—bank commercial

businesses, respectively.

The industrial production series reveals that a recession began

in the U.S. during 1929. By late 1930 the downturn, although serious,

was still comparable in magnitude to the recession of 1920—22; as the

decline slowed, it would have been reasonable to expect a brisk

recovery, just as in 1922.

With the first banking crisis, however, there came what Friedman

and Schwartz called a "change in the character of the contraction."20

The economy first flattened out, then went into a new tailspin just as

the banks began to fail again in June 1931.

A lengthy slide of both the general economy and the financial

system followed. The banking situation calmed in early 1932, and

non—bank failures peaked shortly thereafter. A new recovery attemptbegan in August but failed within a few months.21 In March 1933 the

bottom was reached for both the financial system and the economy as awhole. Measures taken after the banking holiday ended the bank runsand greatly reduced the burden of debt. Simultaneously aggregate

output began a recovery that was sustained until 1937.

The leading explanation of the correlation between the conditions

of the financial sector and of the general economy is that of Friedman

and Schwartz, who stressed the effects of the banking crises on the

—11—

supply of money. We agree that money was an important factor in

1930—33, but, because of reservations cited in the Introduction, we

doubt that it completely explains the financial sector—aggregate

output connection. This motivates our study of a non—monetary channel

through which an additional impact of the financial crisis may have

been felt.

III. The Effect of the Crisis on the Cost of Credit Intermediation.

This paper posits that, in addition to its effects via the money

supply, the financial crisis of 1930—33 affected the macroeconomy by

reducing the quality of certain financial services, primarily credit

intermediation. The basic argument is to be made in two steps.

First, it must be shown that the disruption of the financial sector bythe banking and debt crises raised the real cost of intermediation

between lenders and certain classes of borrowers. Second, the link

between higher intermediation costs and, the decline in aggregate

output must be established. We present here the first step of the

argument, leaving the second to be developed in Sections IV-VI.

In order to discuss the quality of performance of the financial

sector, we must first describe the real services that the sector is

supposed to provide. The specification of these services depends on

the model of the economy one has in mind. We shall clearly riot be

interested in economies of the sort described by Farna (1980), in which

financial markets are complete and information/transactions costs can

be neglected. In such a world banks and other intermediaries are

merely passive holders of portfolios. Banks' choice of portfolios or

the scale of the banking system can never make any difference in this

—12-.

case, since depositors can offset any action taken by banks through

private portfolio decisions.22

As an alternative to the Fama complete—markets world, consider

the following stylized description of the economy. Let us suppose

that savers have many ways of transferring resources from present to

future, such as holding real assets or buying the liabilities of

governments or corporatIons on well—organized exchanges. One of the

options savers have is to lend resources to a banking system. The

banks also have a menu of different assets to choose from. We assume,

however, that banks specialize in making loans to small, idiosyncratic

borrowers whose liabilities are too few in number to be publicly

traded. (Here is where the complete—markets assumption is dropped.)

The small borrowers to whom the banks lend will be taken, for

simplicity, to be of two extreme types, "good" and "bad". "Good"

borrowers desire loans in order to undertake individual—specific

investment projects. These projects generate a random return from a

distribution whose mean will be assumed always to exceed the social

opportunity cost of investment. If this risk is nonsystematic,

lending to good borrowers is socially desirable. "Bad" borrowers try

to look like good borrowers, but in fact they have no "project". Bad

borrowers are assumed to squander any loan received in profligate

consumption, then to default. Loans to bad borrowers are socially

undesirable.

In this model, the real service performed by the banking system

is the differentiation between good and bad borrowers.23 For a

competitive banking system we define the cost of credit intermediation

(CCI) as being the cost of channeling funds from the ultimate

— 1 3—

savers/lenders into the hands of good borrowers. The CCI includes

screening, monitoring, and accounting costs, as well as the expected

losses inflicted by bad borrowers. Banks presumably choose operating

procedures that minimize the CCI. This is done by developing

expertise at evaluating potential borrowers; establishing long—term

relationships with customers; and offering loan conditions that

encourage potential borrowers to self—select in a favorable way.2

Given this simple paradigm, we can describe the effects of the

two main components of the financial crisis on the efficiency of the

credit allocation process (that is, on the CCI).

1. Effect of the bank crises on the CCI. The banking

problems of 1930—33 disrupted the credit allocation process by

creating large, unplanned changes in the channels of credit flow.

Fear of runs led to large withdrawals of deposits, precautionary

increases in reserve—deposit ratios, and an increased desire by banks

for very liquid or re—discountable assets. These factors, plus the

actual failures, forced a contraction of the banking system's role in

the intermediation of credit. Some of the slack was taken up by the

growing importance of alternative channels of credit (see below).

However, the rapid switch away from the banks (given the banks'

accumulated expertise, information, and customer relationship no

doubt Impaired financial efficiency and raised the Cd.25

It would be useful to have a direct measure of the CCI;

unfortunately, no really satisfactory empirIcal representation of this

concept is available. Reported commercial loan rates reflect loans

that are actually made, not the shadow cost of bank funds to a

representative potential borrower; since banks in a period of

—1 LI_

retrenchment make only the safest and highest—quality loans, measured

loan rates may well move inversely to the CCI. We obtained a number

of interesting results using the yield differential between Baa

corporate bonds and U.S. government bonds as a proxy for the CCI;

however, the use of the Baa rate is not consistent with our story that

bank borrowers are those whose liabilities are too few to be publicly

traded.

While we cannot observe directly the effects of the banking

troubles on the CCI, we can see their impact on the extension of bank

credit: Table 1 gives some illustrative data. Column L$ gives, as a

measure of the flow of bank credit, the monthly change in bank loans

outstanding, normalized by monthly personal income.26 One might have

expected the loan—change—to—income ratio to be driven primarily by

loan demand and thus by the rate of production. Comparison with the

first two columns of Table 2 shows, however, that the banking crises

were as important a determinant of this variable as output. For

example, except for a brief period of liquidation of speculation loansafter the stock market crash, credit outstanding declined very littlebefore October 1930——this despite a 25% fall in industrial production

that had occurred by that time. With the first banking crisis of

November 1930, however, a long period of credit contraction was

initiated. The shrinkage of credit shared the rhythm of the banking

crises; for example, in October 1931, the worst month for bank failure

before the bank holiday, net credit reduction was a record 31% of

personal income.

The fall in bank loans after November 1930 was not simply a

balance—sheet reflection of the decline in deposits. Column 5 in

—15—

Table 1 gives the monthly ratio of outstanding bank loans to the sum

of demand and time deposits. This ratio declined sharply as banks

switched out of loans and into more liquid investments.The perception that the banking crises and the associated

scrambles for liquidity exerted a deflationary force on bank creditwas shared by writers of the time. A 1932 National IndustrialConference Board survey of credit conditions reported that

"During 1930, the shrinkage of commercial loansno more than reflected business recession. During1931 and the first half of 1932 Ithe period studied],it unquestionably represented pressure by banks oncustomers for repayment of loans and refusal by banksto grant new loans." [note 27]

Other contemporary sources, including other surveys of credit

conditions, tended to agree.28

Two other observations about the contraction of bank credit can

be made. First, the class of borrowers most affected by credit

reductions were households, farmers, unincorporated businesses, and

small corporations; this group had the highest direct or indirect

reliance on bank credit. Second, the contraction of bank credit was

twice as large as that of other major countries, even those which

experienced comparable output declines.29

The fall in bank loans outstanding was partly offset by the

relative expansion of alternative forms of credit. In the area of

consumer finance, retail merchants, service creditors and non—bank

lending agencies improved their position relative to banks and

primarily bank—supported installment finance companies.3° Small firms

during this period significantly reduced their traditional reliance on

banks in favor of trade credit.31 But, as argued above, in a world

—16—

with transactions costs and the need to discriminate among borrowers,

these shifts in the loci of credit intermediation must have at least

temporarily reduced the efficiency of the credit allocation process,

thereby raising the effective cost of credit to potential borrowers.

2. The effect of bankruptcies on the CCI. We turn now to a

brief discussion of the impact of the increase in defaults andbankruptcies during this period on the cost of credit intermediation.

The very existence of bankruptcy proceedings, rather than being

an obvious or natural phenomenon, raises deep questions of economic

theory. Why, for example, do the creditor and defaulted debtor make

the payments to third parties (lawyers, administrators) that these

proceedings entail, instead of somehow agreeing to divide those

payments between themselves? In a complete—markets world, bankruptcy

would never be observed; this is because complete state—contingent

loan agreements would uniquely define each party s obligations in allpossible circumstances, rendering third—party arbitration unnecessary.

That we do observe bankruptcies, in our incomplete—markets world,

suggests that creditors and debtors have found the combination of

simple loan arrangements and ex post adjudication by bankruptcy (when

necessary) to be cheaper than attempting to write and enforce complete

state—contingent contracts.

To be more concrete, let us use our "good borrower——bad borrower"

example. In writing a loan contract with a potential borrower, the

bank has two polar options. First, it might try to approximate the

complete state—contingent contract by making the borrowers actions

part of the agreement and by allowing re—payment to depend on the

outcome of the borrower's "project". This contract, if properly

—17—

written and enforced, would completely eliminate the possibility of

either side nt being able to meet its obligations; its obvious

drawback is the cost of monitoring which it involves. The bank's

other option is to write a very simple agreement ("payment of

such—amount to be made on such—date"), then to make the loan only if

it believes that the borrower is likely to repay. The second approach

usually dominates the first, of course, especially for small

borrowers.

A device which makes the cost advantage of the simpler approach

even greater is the use of collateral. If the borrower has wealth

that can be attached by the bank in the event of non-payment, the

bank's risk is low. Moreover, the threat of loss of collateral

provides the right incentives for borrowers to use loans only for

profitable projects. Thus, the combination of collateral and simple

loan contracts helps to create a low effective CCI.

A useful way to think of the 1930—33 debt crisis is as the

progressive erosion of borrowers' collateral relative to debt burdens.

As the representative borrower became more and more insolvent, banks

(and other lenders as well) faced a dilemma. Simple, non—contingent

loans faced increasingly higher risks of default; yet a return to the

more complex type of contract involved many other costs. Either way,

debtor insolvency necessarily raised the CCI for banks.

One way for banks to adjust to a higher CCI is to increase the

rate that they charge borrowers. This may be counterproductive,

however, if higher interest charges increase the risk of default. The

more usual response is for banks just not to make loans to some people

that they might have lent to in better times. This was certainly the

—18—

pattern in the 1930s: For example, it was reported that the

extraordinary rate of default on residential mortgages forced banks

and life insurance companies to "practically stop making mortgage

loans, except for renewals."32 This situation precluded many

borrowers, even with good "projects", from getting funds, while

lenders rushed to compete for existing high—grade assets. As one

writer of the time put it:

"We see money accumulating at the centers, withdifficulty of finding safe investment for it;interest rates dropping down lower than everbefore; money available in great plenty for thingsthat are obviously safe, but not available at allfor things that are in fact safe, and which undernormal conditions would be entirely safe (and thereare a great many such), but which are now viewedwith suspicion by lenders." (note 33)

As this quote suggests, the idea that the low yields on Treasury or

blue—chip corporation liabilities during this time signalled a general

state of "easy money" is mistaken; money was easy for a few safe

borrowers but difficult for everyone else.

An indicator of the strength of lender preferences for safe,

liquid assets (and hence of the difficulty of risky borrowers in

obtaining funds) is the yield differential between Baa corporate bonds

and Treasury bonds (Table 1, column 6). Because this variable

contains no adjustment for the reclassification of firms into higher

risk categories, it tends to understate the true difference in yields

between representative risky and safe assets. Nevertheless, this

indicator showed some impressive shifts, going from 2.5% during

1929—30 to nearly 8% in mid—1932. (The differential never exceeded

3.5% in the sharp 1920—22 recession.) The yield differential

reflected changing perceptions of default risk, of course; but note

— 1 9—

also the close relationship of the differential and the banking

crises (a fact first pointed out by Friedman and Schwartz). Bank

crises depressed the prices of lower quality investments as the fear

of runs drove banks into assets that could be used as reserves or for

re—discounting. This effect of bank portfolio choices on an asset

price could not happen in a Fama—type, complete—markets world.

Finally, it is instructive to consider the experience of a

country that had a debt crisis without a banking crisis. Canada

entered the Depression with a large external debt, much of it payable

in foreign currencies. The combination of deflation and the

devaluation of the Canadian dollar led to many defaults. Internally,

debt problems in agriculture and in mortgage markets were as severe as

in the United States, while major industries (notably pulp and paper)

experienced many bankruptcies.3 Although Canadian bankers did not

face serious danger of runs, they shifted away from loans to safer

assets. This shift toward safety and liquidity, though lesspronounced than in the U.S. case, drew criticism from all facets of

Canadian society. The American Banker of December 6, 1932, reported

the following complaint from a non—populist Canadian politician:

"The chief criticism of our present system appearsto be that in good times credit is expanded to greatextremes...but, when the pinch of hard times is firstbeing felt, credit is suddenly and drastically restrictedby the banks...At the present time, loans are only beingmade when the banks have a very wide margin of securityand every effort is being made to collect outstandingloans. All our banks are reaching out in an endeavorto liquefy their assets..."

Canadian lenders other than banks also tried to retrench: According

to the Financial Post, May 1, 1932 (quoted in Safarian, p.130)

"Insurance, trust, and loan companies were increasinglyunwilling to lend funds with real estate and rental

—20—

values falling, a growing number of defaults of interestand principal, the increasing burden of property taxes,and legislation which adversely affected creditors."

More careful study of the Canadian experience in the Depression

would be useful. However, on first appraisal, that experience does

not seem to be inconsistent with the point that even "good" borrowers

may find it more difficult or costly to obtain credit when there is

extensive insolvency. The debt crisis should be added to the banking

crises as a potential source of disruption of the credit system.

IV. Credit Markets and Macroeconomic Performance.

If it is taken as giv that the financial crisis during the

Depression did interfere with the normal flows of credit, it still

must be shown how this might have had an effect on the course of the

aggregate economy.

There are many ways in which problems in credit markets might

potentially affect the macroeconomy. Several of these could be

grouped under the heading of "effects on aggregate supply". For

example, if credit flows are dammed up, potential borrowers in the

economy may not be able to secure funds to undertake worthwhile

activities or investments; at the same time, savers may have to devote

their funds to inferior uses. Other possible problems resulting from

poorly—functioning credit markets include a reduced feasibility of

effective risk—sharing and greater difficulties in funding large,

indivisible projects. Each of these might limit the economys

productive capacity.

These arguments are reminiscent of some ideas advanced by Gurley

and Shaw (1955), McKinnon (1973), and others in an economic

—21—

development context. The claim of this literature is that immature or

repressed financial sectors cause the "fragmentation" of less

developed economies, reducing the effective set of production

possibilities available to the society.

Did the financial crisis of the 1930s turn the United States into

a "temporarily underdeveloped economy" (to use Bob Hall's felicitous

phrase)? Although this possibility is intriguing, the answer to the

question is probably no. While many businesses did suffer drains of

working capital and investment funds, most-larger corporations entered

the decade with sufficient cash and liquid reserves to finance

operations and any desired expansion (see, for example, Lutz (1915)].

Unless it is believed that the outputs of large and of small

businesses are not potentially substitutes, the aggregate supply

effect must be regarded as not of great quantitative importance.

The reluctance of even cash—rich corporations to expandproduction during the Depression suggests that consideration of theaggregate demand channel for credit market effects on output may be

more fruitful. The aggregata demand argument is in fact easy to make:

A higher cost of credit intermediation for some borrowers (e.g.,

households and smaller firms) implies that, for a given safe interest

rate, these borrowers must face a higher effective cost of credit.

(Indeed, they may not be able to borrow at all.) If this higher rate

applies to household and small firm borrowing but not to their saving

(they may only earn the safe rate on their savings), then the effect

of higher borrowing costs is unambiguously to reduce their demands for

current—period goods and services. This pure substitution effect (of

future for present consumption) is easily derived from the classical

—22—

two—period model of savings. [The classical model may be augmented,

if the reader desires, by considerations of liquidity constraints,

bankruptcy costs, or risk—aversion; see Bernanke (1981).)

Assume that the behavior of borrowers unaffected by credit market

problems is unchanged. Then the paragraph above implies that, for a

given safe rate, an increase in the cost of credit intermediation

reduces the total quantity of goods and services currently demanded.

That is, the aggregate demand curve, drawn as a function of the safe

rate, is shifted downward by a financial crisis. In any macroeconomic

model one cares to use, this implies lOwer output and lower safe

interest rates. Both of these outcomes characterized 1930—33, of

course.

Some evidence on the magnitude of the effect of the financialmarket problems on aggregate output is now presented.

V. Short-run Macroeconomic acts of the Financial Crisis.This section studies the short—run or "impact" effects of the

financial crisis. For this purpose, we use only monthly data on therelevant variables. In addition, rather than consider the 1929—33episode outside of its context, we have widened the sample to includethe entire interwar period (January 1919 — December 19141).

Section 11.3 above has already given some evidence of the

relationship between the troubles of the financial sector and those of

the economy as a whole. However, support for the thesis of this paper

requires that non—monetary effects of the financial crisis on output

be distinguished from the monetary effects studied by Friedman and

Schwartz. Our approach will be to fit output equations using monetary

—23—

variables, then to show that adding proxies for the financial crisis

substantially improves the performance of these equations. Comparison

of financial to totally non—financial sources of the Depression, such

as those suggested by Temin (1976), is left to future research.

To isolate the purely monetary influences on the economy, one

needs a structural explanation of the money—income relationship.

Lucas (1972) has presented a formal model in which monetary shocks

affect production decisions by causing confusion about the price

level. Influenced by this work, most recent empirical studies of the

role of money have related national income to measures of

"unanticipated" changes in money or prices.35

The most familiar way of constructing a proxy for unanticipated

components of a variable is the two—step method of Barro (1978), in

which the residuals from a first—stage prediction equation for (say)

money are employed as the independent variables in a second-stage

regression. We experimented with both the Barro approach and some

alternatives.36 Since our conclusions were unaffected by choice of

technique, we report here only the Barro—type results.

In the spirit of the Lucas-Barro analysis, we considered the

effects of both "money shocks" and "price shocks" on output. Money

shocks (M_Me) were defined as the residuals from a regression of the

rate of growth of Ml on four lags of the growth rates of industrial

production, wholesale prices, and Ml itself; price shocks (p_pc) were

defined symmetrica].ly.37 We used ordinary least squares to estimate

the effects of money and price shocks on the rate of growth of

industrial production, relative to trend.

The basic regression results for the interwar sample period are

—211—

given as equations (11.1) and (11.2) in Table 2. These two equations

are of interest, independently of the other results of this paper.

The estimated "Lucas supply curve", equation (11.2), shows an effect of

price shocks on output that is statistically and economically

significant. As such, it complements the results of Sargent (1976),

who found a similar relationship for the postwar. The relationship of

output to money surprises, equation (11.1), is a bit weaker. The fact

that we discover a smaller role for money in the monthly data than

does Evans (1981) is primarily the result of our inclusion of lagged

values of production on the right—hand side. This inclusion seems

justified both on statistical grounds and for the economic reason that

costs of adjusting production can be presumed to create a serial

dependence in output. Like Evans, we were not able to find effects of

money (or prices) lagged more than three months.

While these regression results exhibit statistical significance

and the expected signs for coefficients, they are disappointing in thefollowing sense: When equations (11.1) and (11.2) are used to perform

dynamic simulations of the path of output between mid—1930 and the

bank holiday of March 1933, they capture no more than half of the

total decline of output during the period. This is the basis of the

comment in the Introduction that the declines in money seem"quantitatively insufficient" to explain what happened to output in

1930—33.

Given the basic regressions (11.1) and (11.2), the next step was to

examine the effects of including proxies for the non—monetaryfinancial impact as explanators of output. Based on the earlier

analysis of this paper, the most obvious such proxies are the deposits

—25—

of failing banks and the liabilities of failing businesses.

A preliminary problem with the bank deposits series that needs to

be discussed is the value for March 1933, the month of the bank

holiday. As can be seen in Table 1 , the deposits of banks suspended

in March 1933 is seven times that of the next worse month. The

question arises if any adjustment should be made to that figure before

running the regressions.

We believe that it would be a mistake to eliminate totally the

bank holiday episode from the sample. According to contemporary

accounts, rather than being an orderly and planned—in—advance policy,

the imposition of the holiday was a forced response to the most

panicky and chaotic financial conditions of the period. The depositsof suspended banks figure for March, as large as it is, reflects notall closed banks but only those not licensed to re—open by June 30,1933. Of these banks, most were liquidated or placed in receivership;less than 25% had been licensed to re—open as of December 31, 1936.38

Qualitatively, then, the March 1933 episode resembled the earlier

crises; it would be throwing away Information not to include in some

way the effects of this crisis and of its resolution on the economy.

On the other hand, the mass closing of banks by government action

probably created less confusion and fear of future crises than would

have a similar number of suspensions occurring without government

intervention. As a conservative compromise, we assumed that the

"supervised" bank closings of March 1933 had the same effect as an"unsupervised" bank crisis involving 15% as much in frozen deposits.This scales down the March 1933 episode to about the size of theevents of October 1931. The sensitivity of the results to this

—26—

assumption is as follows: Increasing the amount of importance

attributed to the March 1933 crisis raises the magnitude and

statistical significance of the measured effects of the financial

crises on output. (It is in this sense that the 15% figure is

conservative.) However, the bank failure coefficients in the

regressions retained high significance even when less weight was given

to March 1933.

We turn now to the results of adding (real) deposits of failing

banks and liabilities of failing businesses to the output equations

(11.3 and 4•14 in Table 2). (The sample period begins in 1921 because

of the unavailability of data on monthly bank failures before then.)

In both regressions current and lagged first differences of the added

variables enter the explanation of the growth rate of industrial

production (relative to trend) with the expected sign and, takenjointly, with a high level of statistical significance. The

magnitudes and significance of the coefficients of money and price

shocks are not much changed. This provides at least a tentative

confirmation that non—monetary effects of the financial crisis

augmented monetary effects in the short—run determination of output.Some alternative proxies for the non—monetary component of the

financial crisis were also tried. For the sake of space, only a

summary of these results is given: 1) To examine the direct effects

of the contraction of bank credit on the economy, we began by

regressing the rate of growth of bank loans on current and laggedvalues of suspended bank deposits and of failing business liabilities.(This regression indicated a powerful negative effect of financial

crisis on bank loans.) The fitted series from this regression was

—27—

used as a proxy for the portion of the credit contraction induced byte financial crisis. In the presence of money or price shocks, theeffect of a decline in this variable on output was found to benegative for two months, positive for the next two months, thenstrongly negative for the fifth and sixth months after the decline.

For the period from 1921 until the bank holiday, and with monetary

variables included, the total effect of credit contraction on output

(as measured by the sum of lag coefficients in a polynomial

distributed lag) was large (comparable to the monetary effect),

negative, and significant at the 95% level. For the entire interwar

sample, however, the statistical significance of this variable was

much reduced. This last result is due to the fact that the recovery

of 1933_Lfl was financed by non—bank sources, with bank loans remaining

at a low level.

2) Another proxy for the financial crisis that was tried was the

differential between Baa corporate bond yields and the yields on U.S.

bonds. As described in Section 11.3, this variable responded strongly

to both bank crises and the problems of debtors, and as such was a

sensitive indicator of financial market conditions. The yield

differential variable turned out to enter very strongly as an

explanator of current and future output growth, overall and in every

subsample. As much of this predictive power was no doubt due to pure

financial market anticipations of future output declines, we also putthe differential variable through a first—stage regression on the

liabilities of bank and business failures. Assuming that these latter

variables themselves were not determined by anticipations of future

output declines (see below), the use of the fitted series from this

—28—

regression "purged" the differential variable of its pure anticipatory

component. The fitted series entered the output equations less

strongly than the raw series, but it retained the right sign and

statistical significance at the 95% confidence level.

In almost every case, then, the addition of proxies for the

general financial crisis improved the purely monetary explanation of

short—run (monthly) output movements. This finding was robust to the

obvious experiments. For example, with the above—noted exception of

the credit variable in 1933—kl, coefficients remained roughly stable

over subsamples. Another experiment was to include free dummy

variables for each quarter from 1931:1 to 1932:IV in the above

regressions. The purpose of this was to test the suggestion that our

results are only a reflection of the fact that both the output and

financial crisis variables "moved a lot" during 1930—33. The rathersurprising discovery was that the inclusion of the dummies increasedthe magnitude and statistical significance of the coefficients on bankand business failures. Finally, the economic significance of the

results was tested by using the various estimated equations to run

dynamic simulations of monthly levels of industrial production

(relative to trend) for mid—1930 to March 1933. Relative to the pure

money—shock and price—shock simulations described above, the equations

including financial crisis proxies did well. Equations (p.3) and

(U.14) reduced the mean squared simulation error over (p.1) and (4.2)

by about fifty per cent. The other (nonreported) equations did

better; e.g., those using the yield differential variable reduced the

MSE of simulation from ninety to ninety—five per cent.

These results are promising. However, a caveat must be added:

—29—

To conclude that the observed correlations support the theory outlined

in this paper requires an additional assumption, that failures of

banks and commercial firms are not caused by anticipations of (future)

changes in output. To the extent that, say, bank runs are caused by

the receipt of bad news about next month's industrial production, the

fact that bank failures tend to lead production declines does not

prove that the bank problems are helping to cause the declines.39

While it may not be possible to convince the determined skeptic

that bank and business failures are not purely anticipatory phenomena,

a good case can be made against that position. For example, while in

some cases a bad sales forecast may induce a firm to declare

bankruptcy, more often that option is forced by insolvency (a result

of past business conditions). For banks, it might well be argued that

not only are failures relatively independent of anticipations about

output, but that they are not simply the product of current and past

output performance either: First, banking crises had never previous

to this time been a necessary result of declines in output.0 Second,

Friedman and Schwartz, as well as other writers, have identified

specific events that were important sources of bank runs during1930—33. These include the revelation of scandal at the Bank of theUnited States (a private bank, which in December 1930 became the

largest bank to fail up to that time); the collapse of the

Kreditanstalt in Austria and the ensuing financial panics in centralEurope; Britain's going oft gold; the exposure of huge pyramiding

schemes in the U.S. and Europe; and others, all connected very

indirectly (if at all) with the path of industrial production in the

United States.

—30—

If it is accepted that bank suspensions and business bankruptcies

were the product of factors beyond pure anticipations of output

decline, then the evidence of this section supports the view thatnon—monetary aspects of the financial crisis were at least part of thepropagatory mechanism of the Great Depression. If it is furtheraccepted that the financial crisis contained large exogenouscomponents (there is evidence for this in the case of the bankingpanics), then there are elements of causality in the story as well.

VI. Persistence of' the Financial Crisis

The claim was made in the Introduction that our theory seems

capable, unlike the major alternatives, of explaining the unusual

length and depth of the Depression. In the previous section we

attempted to deal with the issue of depth; simulations of theestimated regressions suggested that the combined monetary and

non—monetary effects of the financial crisis can explain much of theseverity of' the decline in output. In this section the question of

the length of' the Depression is addressed.As a matter of theory, the duration of the credit effects

described in Section III above depends on the amount of time it takes

to 1) establish new or revive old channels of' credit flow after a

major disruption, and 2) rehabilitate insolvent debtors. Since these

processes may be difficult and slow, the persistence of non—monetary

effects of financial crisis has a plaus1ble basis. (In contrast,

persistence of purely monetary effects relies on the slow diffusion of'

information or unexplained stickiness of wages and prices.) Of

course, plausibility is not enough; some evidence on the speed of

—31—

financial recovery should be adduced.

After struggling through 1931 and 1932, the financial system hit

its low point in March 1933, when the newly—elected President

Roosevelt's "bank holiday" closed down most financial intermediaries

and markets. March 1933 was a watershed month in several ways: It

marked not only the beginning of economic and financial recovery but

also the introduction of' truly extensive government involvement in all

aspects of the financial system. It might be argued that the

Federally—directed financial rehabilitation——which took strong

measures against the problems of both creditors and debtors——was the

only major New Deal program that successfully promoted economic

recovery.2 In any case, the large government intervention is prima

facie evidence that by this time the public had lost confidence in the

self—correcting powers of the financial structure.

Although the government's actions set the financial system on its

way back to health, recovery was neither rapid nor complete. Many

banks did not re—open after the holiday, and many that did open did so

on a restricted basis or with marginally solvent balance sheets.

Deposits did not flow back into the banks in great quantities until

193)4, and the government (through the Reconstruction Finance

Corporation and other agencies) had to continue to pump large sums

into banks and other intermediaries. Most important, however, was a

noticeable change in attitude among lenders; they emerged from the

1930—33 episode chastened and conservative. Friedman and Schwartz

(pp. 14)4962) have documented the shift of banks during this time away

from making loans toward holding safe and liquid investments. The

growing level of bank liquidity created an illusion (as Friedman and

—32—

Schwartz pointed out) of "easy money"; however, the combination of'

lender reluctance and continued debtor insolvency interfered with

credit flows for several years after 1933.

Evidence of post—holiday credit problems is not hard to find.

For example, small businesses, which (as we have noted) suffered

disproportionately during the Contraction, had continuing difficulties

with credit during recovery. Kimmel (1939) carried out a survey of

credit availability during 1933—38 as a companion to the National

Industrial Conference Board's 1932 survey: His conclusions are

generally sanguine (this may reflect the fact that the work was

commissioned by the American Bankers Association). However, his

survey results (p. 65) show that, of responding manufacturing firms

normally dependent on banks, refusal or restriction of bank credit was

reported by 30.2% of very small firms (capitalization less than

$50,000); 114.3% of small firms ($50,001 — $500,000); 10.3% of medium

firms ($500,001 — $1,000,000); and 3.2% of the largest companies

(capital over $1 million). (The corresponding results from the 1932

NICE survey were 141.3%, 22.2%, 12.5%, and 9.7%.)

Two well—known economists, Hardy and Viner, conducted a credit

survey in the Seventh Federal Reserve District in 19314—35. Based on

"intensive coverage of 2600 individual cases", they found "a genuine

unsatisfied demand for credit by solvent borrowers, many of whom could

make economically sound use of working capital...The total amount of

this unsatisfied demand for credit is a significant factor, among many

others, in retarding business recovery." They added, "So far as small

business is concerned, the difficulty in getting bank credit has

increased more, as compared with a few years ago, than has the

—33—

difficulty of getting trade credit."3

Finally, another credit su'vey for the 1933—38 period was done by

the Small Business Review Committee for the U.S. Department of

Commerce. This study surveyed 6000 firms with between 21 and 150

employees. From these they chose a special sample of 600 companies

"selected because of their high ratings by a standard commercial

rating agency". Even within the elite sample, 5% of the firms

reported difficulty in securing funds for working capital purposes

during this period; and 75% could not obtain capital or long—term loan

requirements through regular markets.

The reader may wish to view the American Bankers Association and

Small Business Review Committee surveys as lower and upper bounds,

with the Hardy—Viner study in the middle. In any case, the consensus

from surveys, as well as the opinion of careful students such as

Chandler, is that credit difficulties for small business persisted for

at least two years after the bank holiday.5

Home mortgage lending was another important area of credit

activity. In this sphere private lenders were even more cautious

after 1933 than in business lending. They had a reason for

conservatism; while business failures fell quite a bit during the

recovery, real estate defaults and foreclosures continued high through

1935.6 As has been noted, some traditional mortgage lenders nearly

left the market: Life insurance companies, which made $525 million in

mortgage loans in 1929, made $10 million In new loans in 1933 and $16

million in 193ZL47 During this period, mortgage loans that were made

by private institutions went only to the very best potential

borrowers: Evidence for this is the sharp drop in default rates of

—3k;—

loans made in the early 1930s as compared to loans made in earlier

years (see Behrens (1952, p. 11)); this decline was too large to be

explained by the improvement in business conditions alone.

To the extent that the home mortgage market did function in the

years immediately following 1933, it was largely due to the direct

involvement of the Federal government. Besides establishing some

important new institutions (such as the FSLIC and the system of

Federally—chartered savings and loans), the government "readjusted"

existing debts, made investments in the shares of thrift institutions,and substituted for recalcitrant private institutions in the provisionof direct credit. In 193L, the government—sponsored Home Owners' Loan

Corporation made 71% of all mortgage loans extended.8

Similar conditions obtained for farm credit and in other markets,

but space does not permit this to be pursued here. Summarizing the

reading of all of the evidence by us and by other students of the

period, it seems safe to say that the return of the private financialsystem to normal conditions after March 1933 was not rapid; and that

the financial recovery would have been more difficult without

extensive government intervention and assistance. A moderate estimate

is that the U.S. financial system operated under handicap for aboutfive years (from the beginning of 1931 to the end of 1935), a periodwhich covers most of the time between the recessions of 1929—30 and

1937—38. This is consistent with the claim that the effects offinancial crisis can help explain the persistence of the Depression.

VII. International AectsThe Depression was a worldwide phenomenon; banking crises, though

—35—

occurring in a number of important countries besides the U.S., were

not so ubiquitous. A number of large countries had no serious

domestic banking problems, yet experienced severe drops in real income

in the early 1930s. Can this be made consistent with the important

role we have ascribed to the financial crisis in the U.S.? A complete

answer would require another paper; but we will offer some

observations:

1) The experience of different countries and the mix of

depressive forces each faced varied significantly. For example,

Britain, suffering from an overvalued pound, had high unemployment

throughout the 1920s; after leaving gold in 1931, it was one of the

first countries to recover. The biggest problems of food and raw

materials exporters were falling prices and the drying up of overseas

markets. Thus we need not look to the domestic financial system as an

important cause in every case.

2) The countries in which banking crises occurred (the U.S.,

Germany, Austria, Hungary, and others) were among the worst—hit by the

Depression. Moreover, these countries held a large share of world

trade and output. The U.S. alone accounted for almost half of world

industrial output in 1925—29, and its imports of basic raw materials

and foodstuffs in 1927-28 made up almost O% of the trade in these

commodjtjes.19 The reduction of imports as these economies weakened

exerted downward pressure on trading partners.

3) There were interesting parallels between the troubles of the

domestic financial system and those of the international system. One

of the Federal Reserve's proudest accomplishments had been the

establishment, during the 1920s, of an international gold—exchange

— 36—

standard. Unfortunately, like domestic banking, the gold—exchange

standard had the instability of a fractional—reserve system.

International reserves included not only gold but also foreign

currencies, notably the dollar and the pound; for countries other than

the U.S. and the U.K., foregn exchange was 35% of total reserves.

In 1931 expectations that the international financial system

would collapse became self—fulfilling. A general attempt to convert

currencies into gold drove one currency after another off the

gold—exchange standard. Restrictions on the movement of capital or

gold were widely imposed. By 1932 only the U.S. and a small number of

other countries remained on gold.

As the fall of the gold standard parallelled domestic bank

failures, the domestic insolvency problem had an international

analogue as well. Largely due to fixed exchange rates, the deflationof prices was worldwide. Countries with large nominal debts, notablyagricultural exporters (the case of Canada has been mentioied), became

unable to pay. Foreign bond values in the U.S. were extremely

depressed.

As in the domestic economy, these problems disrupted the

worldwide mechanism of credit. International capital flows were

reduced to a trickle. This represented a serious problem for many

countries.

Thus the fact that the Depression hit countries which did not

have banking crises does not preclude the possibility that banking and

debt problems were important in the U.S. (or, for that matter, that

countries with strong banks had problems with debtor insolvency).

Moreover, our analysis of the domestic financial system may be able to

—37—

shed light on some of the international financial difficulties of theperiod.

VIII. Conclusion

Did the financial collapse of the early 1930s have real effects

on the macroeconomy, other than through monetary channels? The

evidence is at least not inconsistent with this proposition. However,

a stronger reason for giving this view consideration is the one stated

in the Introduction: This theory has hope of achieving a

reconciliation of the obvious sub—optimality of this period with the

postulate of reasonably rational, market—constrained agents. The

solution to this paradox lies in recognizing that economic

institutions, rather than being a "veil", can affect costs of

transactions and thus market opportunities and allocations.

Institutions which evolve and perform well in normal times may become

counterproductive during periods when exogenous shocks or policy

mistakes drive the economy off—course. The malfunctioning of

financial institutions during the early 1930s exemplifies this point.

—38—

Table 1. Selcc ted macroeconomic data, Ju 1929 - March 1933

Month IP Banks Falls AL/PI L/DEP DIP

1929J 114 60.8 32.4 .163 .851 2.31

A 114 6.7 33.7 .007 .855 2.33

S 112 9.7 34.1 .079 .860 2.33

0 110 12.5 31.3 .177 .865 2.50

N 105 22.3 52.0 .121 .854 2.68

D 100 15.5 62.5 —.214 .851 2.59

1930J 100 26.5 61.2 —.228 .837 2.49

F 100 32.4 51.3 —.102 .834 2.48

M 98 23.2 56.8 .076 .835 2.44

A 98 31.9 49.1 .058 .826 2.33

M 96 19.4 55.5 —.028 .820 2.41

J 93 57.9 63.1 .085 .818 2.53

J 89 29.8 29.8 —.055 .802 2.52A 86 22.8 149.2 —.027 .800 2.47

3 85 21.6 46.7 .008 .799 2.41

0 83 19.7 56.3 —.010 .791 2.73N 81 179.9 55.3 —.067 .777 3.06D 79 372.1 83.7 —.144 .775 3.49

1931J 78 75.7 914.6 —.187 .763 3.21

F 79 34.2 59.6 —.144 .747 3.08

M 80 34.3 60.$ —.043 .738 3.17

A 80 41.7• 50.9 —.104 .722 3.45

M 80 43.2 53.4 —.133 .706 3.99

— 39—

1931J

J

A

S

0

N

D

1932J

F

M

A

M

II

J

A

S

0

N

D

1933J

F

77

76

73

70

68

67

66

64

63

62

58

56

514

53

54

58

60

59

58

58

57

190. 5

40.7

180.0

233.5

117 1 .14

67.9

277.1

218.9

51.7

10.9

31.6

311.14

132.7

148.7

29.5

13.5

20 • 1

43.3

70.9

133.1

62.2

Table 1 (continued)

M 54 3276.3' 48.5 —.767' .607' 14.03

51.7

61.0

53.0

117.3

70.7

60.7

73.2

96.9

811.9

93.8

101 • 1

83.8

76.9

87.2

77.0

56.1

52.9

53.6

614.2

79.1

65.6

—. 1 20

—.013

—.103

—.050

—.310

—.101

—.120

—.117

—.138

—.183

—.225

—.154

—.170

—.219

—.130

—.091

—.095

—.133

—.039

—.139

—.059

.707

.7014

.706

.713

.716

.726

.732

.745

.757

.71111

.718

.696

.689

.677

.662

.6111

.623

.602

• 59 6

.576

.583

11.23

3.93

14 .29

11.82

5.111

5.30

6.119

11.87

4.76

11.91

6.78

7.87

7.93

7.21

11.77

11.19

11.1111

11.79

5.07

11.79

4.09

— zI0_

IF seasonally adjusted index of industrial production, 1935—39100; Federal Reserve Bulletin

Banks deposits of failing banks, $millions; Federal Reserve Bulletin

Fails liabilities of failing commercial businesses, $millions;!!i21 2!. ta2

AL/PI ratio of net extensions of commercial bank loans to (monthly)personal income; from Bank and Moneta Statistics andNational Income

L/D ratio of loans outstanding to the sum of demand and timedeposits, weekly reporting banks; Bank and MonetaStatistics

DIF difference (in percentage points) between yields on Baacorporate bonds and long—term U.S. Government bonds;

!12.a!1 tflft( ) A national bank "holiday" was declared in March 1933

to Table 2 (overleaf)

rate of growth of industrial production (Federal ReserveBulletin), relative to exponential trend

(M_Me)t = rate of growth of Ml, nominal and seasonally adjusted(Friedman and Schwartz, Table 4—1), less predicted rateof growth

(p_pe)t = rate of growth of wholesale price index (Federal ReserveBulletin), less predicted rate of growth

DBANKSt = first difference of deposits of failing banks(deflated by wholesale price index)

DFAILSt = first difference of liabilities of failing businesses(deflated by wholesale price index)

Data are monthly. t—statistics are in parentheses.

_141_

Table 2. Es t I mated ouut uat ions

(4.1) = .623 't_i — .11313 Y_2 + •1so7 (M_Me)(10.21) (—2.37) (3.42)

+ .1141 (M—M) + .051 (M_Me)t + .(1.16) (0.42) —2

(1.19)

s.c. = .0272 D.W. = 2.02 sample: 1/19 — 12/41

(4.2) = .582 + 533 (ppm)(9.50) (176)t_2 (533)

+ .350 (p_pc) + .036 (P_pe) , + .069 (p_pe)3(3.33) (0.34) (0.66)

S.C. = .0260 D.W. = 2.01 sample: 1/19 — 12/131

+ .332 (M_Me) + .113 (M_Me)t_l(23.3) '!t = .613

(23)t_2 (2.92) (0.99)(9.86)

— .869E—014 DBANKSt+ .110 (M_Me)t2 t3

(—13.24)(0.96)

— .406E—0'4DBANKSt 1 - .258E—03 DFAILSt — .325E—03 DFAILSt_i(—1.93) (—1.95) (_2.137)

S.C. .0249 D.W. = 1.99 sample: 1/21 — 12/131

= .615 Y_ — .131 t—2 + .1355 (_e) + .231 (e)(9.76) (—2.13) (3.99) (1.97)

— .004 (p_pc) — . 799E—013 DBANKSt(-0.03)t-2

(-4.03)

2142E—03 DFAILSt_,— .337E—0$ DBANKSt i - .202E—03 DFAILSt —

(—1.66) (—1.52)

S.C. = .02146 D.W. 1.98 sample: 1/21 — 12/41

—42—

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— L9 —

Notes

1. This is documented more carefully in Sections 11.3 and V below.

2. This paper does not address the causes of the initial 1929—30

downturn. Friedman and Schwartz (1963) have stressed the importance

of the Federal Reserve's "anti—speculative" monetary tightening.

Others, such as Temin (1976) and Gordon and Wilcox (1981), have

pointed out autonomous expenditure effects.

3. See Brunner (1981) for a useful overview of contemporary theories

of the Depression. Also, see Lucas and Rapping's article in Lucas(1981).

. This is especially true of the more recent work, which tends toignore the non—monetary effects of the financial crisis. Older

writers often seemed to take the disruptive impact of the financial

breakdown for granted.

5. We do not deny the possible importance of irrationality in

economic life; however it seems that the best research strategy is topush the rationality postulate as far as it will go.

6. See especially Chandler (1970,1971) and Friedman and Schwartz.

7. Hart (1938) describes the problems of the building—and—loans. An

interesting sidelight here is the additional strain on housing lenders

—50—

caused by the existence of the postal Savings System: see OHara and

Easley (1979).

8. According to Goldsmith (1957), commercial banks held 39.6% of the

assets of all financial intermediaries, broadly defined, in 1929. See

his Table 11.

9. Upham and Lamke (1931k), p. 2I7. Since smaller banks were more

likely to fail, the fraction of deposits represented by suspended

banks is somewhat less. Eventual recovery by depositors was about

75%; see Friedman and Schwartz, p. 38.

10. Kiebaner (197L) gives a good brief history of U.S. commercial

banking.

11. Upham and Lamke, p. 2L7, report that approximately 2—3% of all

banks in operation failed in each year of the 1920s.

12. Diamond and Dybvig (1982) formalize this argument. For an

alternative analysis of the phenomenon of runs, see Flood and Garber

(1981).

13. For example, equity—like instruments, such as those used by

modern money—market mutual funds, could have been used as the

transactions medium. See Cone (1982).

14. Diamond and Dybvig derive this point formally, with some caveats.

—51—

15. Finding an explanation for the lack of indexed debt during the

deflationary 1930s——as in the inflationary 1970s——is a point on which

we stumble.

16. Twentieth Century Fund (1938), p. 164, reporting the results of

t h e Financial Surv of Urban Hous1.

17. Ibid., p. 138.

18. Ibid., p. 225.

19. Chandler (1971), p. 102.

20. Page 311.

21. Judging by Table 1, the failure of this recovery seems to be

unrelated to financial sector difficulties. However, accounts from

the time suggest that the banking crisis of late 1932 and early 1933

(which ended in the banking holiday) was In fact quite severe; see

Kennedy (1973). The relatively low reported rate of bank failures at

this time may be an artifact of state moratoria, restrictions on

withdrawals, and other interventions.

22. It should be noted that the phenomena emphasized by Friedman and

Schwartz——the effects of the contraction of the banking system on the

quantity of the transactions medium and on real output—-are also

—52—

impossible in a complete—markets world.

23. To concentrate on credit intermediation, we neglect the

transactions and other services performed by banks.

24. See Jaffee and Russell (1976) and Stiglitz and Weiss (1981) on

the way banks induce favorable borrower self—selection.

25. Since intermediation resources could have been shifted out of the

beleaguered banking sector (given enough time), ours is basically a

costs—of—adjustment argument.

26. A problem with this series is that loans wiped out by default are

included in the measure of credit contraction. Note, however, that

for our purposes looking at the change in loans is preferable to

considering the stock of real loans outstanding: In a regime of

nominally contracted debt and sharp unanticipated deflation, stability

of the stock of real debt does not signal a comfortable situation for

borrowers.

27. National Industrial Conference Board, p. 28.

28. See Chandler (1971), pp. 233—39.

29. Klebaner, p.

30. Nugent (1939), pp. 11ZI_16.

—53—

31. Merwin (19L$2), p. 5 and p. 75.

32. Twentieth Century Fund, p. 163.

33. Frederiksen (1931), p. 139.

34. Safarian (1959), ch. 7.

35. A notable exception is Mishkin (1981).

36. Principal alternatives tried were 1) the use of anticipated as

well as unanticipated quantities as explanatory variables; and 2)

re—estimation of some equations by the more efficient but

computationally more complex method of Abel and Mishkin (1981).

37. The first—stage regressions were unsurprising and, for the sakeof space, are not reported.

38. Federal Reserve Bulletin, 1937, pp. 866—7.

39. Actually, a similar criticism might be made of Barro's work and

our own money and price regressions.

ZO. Cagan (1965) makes this point; see pp. 216, 227—8. The 1920—22recession, for example, did not generate any banking problems.

41. See Chandler (1970), ch. 15, Friedman and Schwartz, oh. 8.

42. Brown (1956) has argued that New Deal fiscal policy was not very

constructive. A paper by Michael Weinstein in the Brunner volume

(exact reference to be found) pointed out counterproductive aspects of

the N.R.A.

43. These passages are quoted in Stoddard (1940).

44. Ibid.

45. See Chandler (1970), pp. 150—51.

46. Historical Statistics, series N301.

47. Ibid., N282.

48. Ibid., N278 and N283.

49. U.S. Department of Commerce (1949), pp. 29—31.